Can the ECB squash the Australian dollar rally? It’s a question Australian dollar investors should always be cognisant of. The EUR and AUD are closely correlated in terms of trend versus the US dollar:
Largely because EUR is such a large input into DXY:
When the EUR falls it is very difficult for the US dollar index (DXY) to fall as well. In turn, that makes it difficult (though not impossible) for the AUD to rise.
The FT asks the question today:
Investors expect European policymakers to push back against the euro’s rapid appreciation at their final rate-setting meeting of the year on Thursday, but some are questioning whether the central bank can do much to stop the exchange rate from moving higher.
Since the start of the year, the euro has climbed more than 8 per cent against the US dollar, and at the start of December it gained a foothold above $1.20, hitting $1.21 on Friday. Large banks now expect the currency to reach $1.25 in the coming months.
Christine Lagarde, the ECB president, has already highlighted the exchange rate’s negative impact on inflation, saying in September that she expected the eurozone to remain in deflation for a considerable time. But this messaging — reinforced by the central bank’s chief economist Philip Lane in the same month — has had little impact on the euro’s upward march.
…“There is not much that the ECB can actually do to directly affect the [exchange rate],” said Athanasios Vamvakidis, a currency strategist at Bank of America. “It is not about the euro, but about the dollar.” Eva Szalay
For now, that is absolutely right. DXY always falls in the early years of recovery as the end-of-cycle safe-haven trade unwinds into a global search for yield. As well, Europe benefits from the recovery via its monstrous export economy.
There is nothing the ECB can do about this while it lasts.
But for how long? As the cycle begins to settle into more normal patterns, the underlying macro drivers of forex re-present themselves:
- inflation outlooks and relative interest rates;
- trade and fiscal performance;
- growth rates and expectations of return;
- sentiment and technicals.
On most of these Europe has a weaker outlook than the US once we’re through 2021:
- it has chronic lowflation owing to fiscal constraints especially versus US;
- trade performance will eventually be battered by the rising EUR;
- fiscal is always too tight thanks to the incomplete EU project which is currency hawkish by itself but leads to weak growth before long and an ECB that is lower for longer than the Fed;
- China will be the first to tighten and too slow, which also hurt Europe more than the US.
In short, by 2022 or before, I expect the EUR will succumb to these underlying issues and DXY will begin the strengthen.
That caps the Australian dollar upside for the cycle unless, as happened after the GFC, tail risk present themselves, such as commodity super-cycles, US tariffs and the like.
However, these are not my base case, which is that EUR will flame out by necessity sometime next year, and the Australian dollar will also begin to fall before it gets to 80 cents.
